Is value investing dead?

No one wants to pay over the odds for their investments.

If you’re looking to own a fast-growing company, you should only buy the shares if you think the current price doesn’t reflect the full value of its future opportunities. All investors should be looking for good value.

However, when we talk about value investing, we usually mean a style of investing that looks for companies that are truly unloved.

These companies tend to be in undesirable or slow-growing areas, and their ratings – price-to-earnings or price-to-book ratios – are usually much lower than the market average.

Hunting for these companies, with the view they’ll turn around, is a well-established style of investing. It’s proven fruitful for decades. But over the last 10 or so years it’s had a torrid time. We look at why, and see if value investing truly is dead.

This article isn’t personal advice. All investments rise as well as fall in value so you could get back less than you invest. If you’re unsure, please ask for advice.

Value isn’t in vogue

The other side of the coin is usually dubbed growth investing.

Value and growth usually outperform each other in bursts. Value, as a style of investing, might outperform for a few years, followed by growth for the next two or three. But ever since the financial crisis, growth’s been leading the way.

Performance of Value vs Growth

Past performance is not a guide to the future. Source: AQR, 04/08/2020.

The chart above shows the relative performance of value against growth. While value briefly outperformed growth from 2010-15, more recently it’s underperformed by quite some way.

Why is value underperforming?

Coming in to 2020 value companies were rated about as lowly-valued, relative to growth, as they’d ever been. When the pandemic hit, this gap widened even further.

Value companies tend to be cyclical – lots rely on a strong economy to thrive. Worries of a virus-induced economic slowdown hurt sentiment. Investors thought they offered little protection in a downturn.

On the other hand, investors have taken comfort in businesses that might benefit from lockdowns. Lots of big and popular growth companies, like Amazon and Netflix, have only strengthened their positions.

Does value investing still work?

The question of whether or not value investing is dead is, frankly, something nobody knows the answer to.

What we do know is that, historically, investors have been rewarded for investing in lowly-valued companies.

Decades ago academic researchers found and proved that investing in lowly valued companies, on average, grants investors better returns than the wider market – a value premium. It’s similar to the phenomenon we see where smaller companies’ share prices outpace bigger ones.

But after a terrible run of performance even the academics had doubt value is the place to be.

Earlier this year they put value to the test once again. What they found was, while value hasn’t performed as well since their initial research was published, it’s not a write off either. The results weren’t statistically significant enough to say the value premium no longer exists.

Of course, past performance isn’t a guide to the future.

Avoiding value traps

Lots of investors aren’t put off by lowly valued companies. Some of us race to pick up perceived bargains.

Remember though, low share prices are usually low for a reason. One argument for the value premium existing in the first place is that these companies tend to be higher risk. And we’ve written more about the risks of investing in distressed businesses in a recent article.

The dangers of trying to catch a falling knife

Airlines are an example. They’re trading on low valuations, but a lot of these companies have high costs they need to cover. Most of their profit comes from filling the last few seats.

We struggle to see a world where demand for air miles gets back to where it was, at least anytime soon. This might not sound like a huge problem. You can stick it out, right? But a long term shift in demand dramatically changes the picture for these businesses.

Arguably the world’s most successful investor, Warren Buffett, recently sold all his airline companies. And his favourite holding period is “forever”.

Of course there will be winners and losers. But value investments aren’t usually in rising-tides-lift-all-boats areas. Not all of these companies will win.

If you’re hunting for bargains, we think it’s even more important to have good mix in your portfolio.

How it affects your portfolio

History tells us that stock markets get carried away and become far too pessimistic or optimistic.

In a single day last month Amazon added the entire value of Boeing to its valuation, and Tesla added the entire value of Ford. This is on top of already significant gains, and to say there’s scope for disappointment is an understatement.

If everything in your portfolio is moving in the same direction you’re probably not diversified enough. That can be a difficult concept to stomach, especially as a lot of investors today have made lots of money investing in growth.

Remember diversification doesn’t mean owning bad investments, pulling your overall performance down. It’s about smoothing your returns over time. As value and growth tend to perform well at different times, owning a bit of both can help.

How to diversify

It might feel uncomfortable to own some investments that have been performing poorly in recent history. But the difference between growth and value is starting to feel like an elastic band being pulled apart. If value does come back to the limelight, as the research suggests it might, do you want to be all in on growth?

If you’d like more to help you find value opportunities in the future you can sign up to our weekly share insight email below. We’ll send our latest research straight to your inbox every Saturday morning.

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